Panic is never a great attitude to have in investing, but neither is blind optimism. So it's probably healthy for Alibaba (BABA 2.38%) shareholders not to get too overwhelmed by the ongoing Chinese regulatory crackdown, but also not blindly buy the stock just because it's down and other famous investors like Charlie Munger are doing so.
Alibaba released its third-quarter earnings report on Thursday, Nov. 18, and the stock plunged over 10% on the news. While the period did encompass a tumultuous summer for the Chinese economy, some figures did seem to confirm the worst fears over Alibaba's business.
The core business is the biggest issue, and newer segments are unprofitable
The biggest fear I had amid China's regulatory crackdown wasn't necessarily punishing fines or the seizure of Alibaba's business. Amid all of the ideological uproar, China's intention seems to be to level the playing field among businesses and create a more equal and competitive society. Those are all worthy goals, but if successful, new regulations could eat away at Alibaba's competitive advantages.
Although Alibaba is far and away the leader in Chinese e-commerce, it also has very, very formidable competitors in JD.com, Pinduoduo, and others. So new regulations aimed at forbidding exclusivity on platforms and other monopolistic tactics stood to perhaps hurt Alibaba more than competitors.
Unfortunately, that renewed competitive pressure is showing. Alibaba posted what looked like solid 29% overall revenue growth and 33% e-commerce growth, but excluding the acquisition of Sun Art Retail last year, overall organic growth was only 16%.
Diving into different segments of Alibaba's e-commerce empire, the only real profitable segment is "customer management," which is essentially online ad revenue from merchants on Alibaba's platform. That segment only grew 3% in the third quarter. While some would attribute that to difficult yearly comparisons and the Chinese economy, even Alibaba acknowledged competitive pressure played a part, saying the slowdown "resulted from slowing market conditions and more players in the China e-commerce market."
Low growth in Alibaba's most profitable division led to a big 32% decline in the company's adjusted EBITA. That's because basically all of Alibaba's other divisions currently make losses, with an uncertain payoff. Yet even absent those strategic investments, "commerce-adjusted EBITA" in the core business was only flat year over year. So it appears even the key cash-producing core business is feeling margin pressure.
Is there any good news?
While the main story on Alibaba's September quarter was definitely negative, there were a few silver linings. First, the company's cloud computing platform accelerated its growth over the prior quarter, from 29% in the June quarter to 33% in the September quarter. As investors in U.S. cloud companies know, it can be a very lucrative business, so that acceleration was good to see.
However, the cloud business is still unprofitable (although slightly profitable on an EBITA basis) and only makes up 10% of revenue, so success requires some faith Alibaba will turn this into a larger and profitable second main business. Additionally, that growth rate is still below all of the major U.S.-based cloud companies, even though they are all larger than Alibaba's cloud today.
Another silver lining: Alibaba's stock does seem rather cheap at current levels. Despite this being a challenging quarter in terms of profits, Alibaba still made roughly $3.5 billion in free cash flow, even in a "down" quarter that saw that figure cut nearly in half. Alibaba also has a whopping $68.8 billion in cash and equivalents on the balance sheet against debt in the low-$20 billion range, along with another $38 billion or so in investments in other equities.
So Alibaba's current market cap of just $400 billion seems reasonable, even if its profit growth doesn't bounce back to prior growth rates. The company also continues to repurchase stock, buying back over $5 billion in stock last quarter.
It's not doomsday, but Alibaba isn't an obvious buy, either
Since Alibaba's once high-flying stock is still down nearly 50% from its previous all-time highs, some may think it's a bargain. However, it seems Alibaba is going to have to work harder for profitable growth going forward than it did prior to the regulatory overhaul, and this year's sell-off was not unwarranted.
That being said, the company is reasonably priced even based on today's depressed financials, so if any of its strategic investments in "new retail," cloud, or other ventures outside of e-commerce work out, there could be significant upside. But it will take faith and patience to realize that, and I'm a bigger fan of other beaten-down Chinese tech stocks to play a potential rebound in the country.